Valuations in the US are high, exceeding all prior periods in history with the exception of the dot-com bubble (March 1998 to December 2000).1
The long-run implications of higher valuations?
Lower future returns and higher volatility/drawdowns, on average (see recent post).
The natural question that follows: what, if anything, can an investor do about this?
While there are no easy answers, a few options include…
1. International Diversification
US Equities have had a tremendous run, outperforming global equities by a wide margin over the last 10 years…
As a result, US equity valuations are significantly higher than European and Emerging Market equities.2
If US stocks always outperformed, there would be no reason to invest elsewhere. In 2000, like today, many thought that this was the case following a similar run of US outperformance. But in the 10-year period that followed (from 2000 through 2009), the S&P 500 lost 9% while Emerging Markets gained 162%.
US equities represent about 57% of total equity market cap worldwide, meaning a purely passive investor would allocate 43% to equities outside the US. If you have no exposure to international equities, now would seem to be a reasonable time to consider diversifying.
2. Style Diversification
Growth has been outperforming Value for more than a decade, with gains over the last few years accelerating.
The largest US equities, which are heavily influencing elevated US valuations, all reside on the growth side of the spectrum. These include Apple, Microsoft, Amazon, Google, Facebook, and Tesla.
By diversifying into value, you are hedging your bet on their continued outperformance.
If growth always outperformed, there would be little need to diversify. But alas, we have seen many periods in which value has trumped growth. In the 7-year period from 2000 through 2006, Value stocks gained 69% versus a loss of 30% for Growth stocks.
No one knows if a similar period will follow, but if you have no value exposure in your portfolio, now would seem to be a reasonable time to consider it.
3. Asset Class Diversification
Stocks have outpaced bonds by a wide margin over the last 10+ years…
If only went up, there would be little need to own anything else. But alas, they do go down from time to time and when they do it’s been helpful to have some exposure to bonds…
While bonds today provide little in the way of income (current yield of US Aggregate is only 1.53%), they still allow investors to better withstand stock market declines and to hopefully rebalance back into equities at lower prices/valuations. For investors close to retirement or in the early withdrawal stages, bonds play a more critical role as their tolerance for a near-term drawdown and higher volatility tends to be much lower.
The 10-year period from 2000 to 2009 is once again instructive here, as bonds provided a cumulative return of 85% versus a 9% decline for stocks. While the low bond yields today preclude a similar return outcome, the value of bonds during a difficult period for equities remains.
If you have no exposure to bonds in your portfolio, now would seem to be a reasonable time to consider it.
4. Strategy Diversification
When valuations are low and prospective returns are high, you want beta (market exposure) in your portfolio. When the opposite is true as it is today, beta is less desirable, and strategies uncorrelated to long-only equity exposure (known as “alternatives”) become more valuable.
Managed futures provide one such example. During the 2000-2002 period when the S&P 500 posted 3 straight down years and declined 37.6% in total, managed futures were up each year with a cumulative return of over 22%.
If you have no exposure to strategies outside of long-only US equities, now would seem to be a reasonable time to consider it.
5. Lower Expectations
The last option is the most within your control but the least palatable for many.
If higher valuations (and low bonds yields) mean lower future returns, you can combat that in part by saving more, spending less, and retiring later. In lowering your expectations, you can still hope for the best (that high valuations do not lead to lower returns) but be prepared for the worst.
A Consistent Theme
You’ve probably noticed a consistent theme throughout these options: diversify, diversify, diversify. Historically, the best protection against a bubble or elevated valuations in a single asset class (see Japanese equities in 1989, US Tech stocks in 2000, US Housing in 2006, etc.) was to have exposure to other asset classes and strategies that do not have the same underlying fundamental drivers.
Diversification is ultimately an exercise in humility and risk management. For at its core it’s an admission that you cannot predict the future and is employed to withstand the many possible outcomes that lie ahead. One of those possible outcomes is that the high valuations in US equities today portend a more difficult road ahead. If that’s indeed the case, a little diversification can go a long way in helping you navigate that road and stay the course.
1. When I refer to “valuations” here, I am using the CAPE Ratio. This is the Cyclically Adjusted Total Return Price to Earnings Ratio (TR P/E10 or TR CAPE). It is also known as the “Shiller P/E” as it was developed by economist Robert Shiller. Data source: Robert Shiller.
2. EM = an average of the top 4 holdings in the MSCI Emerging Market Index (China, Taiwan, South Korea, and India). Europe = MSCI Europe Index.
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